Looking for a temporary bottom

World stock markets are oversold, and now that the US markets have taken a dip under the May 6 lows we have a stronger case for some near-term strength. The put:call ratio is also advising shorts not to press their luck, though there is still plenty of room on the upside, especially considering that this is indicator tends to oscillate from extreme lows to extreme highs:

Indexindicators.com

I’ve eased up on my short risk portfolio today by selling some puts, closing some ultralong ETF shorts, selling Yen and buying SPX and Nikkei futures. I’ll view any bounce as a shorting opportunity, since unlike most of the people on TV this week I don’t view this sell-off as a correction but the likely start of another leg down in a multi-year bear market.

I tend to be early on closing and easing up shorts, so take note that we don’t have much in the way of bullish action out there yet.

Some thoughts on the bear market.

This post started as an email that got way too long. I added some charts and put it up here:

The rally has not surprised me (on March 31 I expressed the opinion that we would hit 900 or higher by summer:

…more likely in my mind is a protracted rally extending to 900 or higher by summer, then rolling over to meet a date with 400 next winter. Look at last year’s rallies from March to May and July to August for an idea of what this might look like, though on a larger percentage and time scale because we are correcting a larger sell-off. The case for such a move is bolstered when you hear major investment banks’ strategists calling this a dead cat bounce. Too many people are still afraid to call a bottom, and they need to be suckered into long positions before this is over (along the same lines, too many traders are embracing the dead cat bounce and need to be shaken out before it can get back to leading the buy-and-holders to slaughter).

That said, I was leaning closer towards 900 than 1050:

I am highly skeptical, though respectful, of calls for a the mother of all bear market rallies. Robert Prechter and some other Elliott Wavers, as well as Tim Knight (slopeofhope.com) seem to be anticipating a 6-month or longer rally to as high as 1050. I simply don’t see why that is necessary in this environment. This is a depression, and the last one was accompanied by bear market that, after the first 6 months, maintained the momentum of a cruising supertanker. Rallies of 20 percent and 2 months were about all you got from April 1930 to July 1932 as the Dow dropped from about 295 to 41. That deflation-driven event was a much more orderly bear market than the jagged trajectory of the dot-com crash, which occured while the credit bubble continued to expand. Interestingly, the 1966-1982 secular bear (a brutal 75% loss in real terms) also traced out such a series of steep plunges and rallies as the bubble kept inflating thanks to a compliant Fed and the abandonment of the last trace of the gold standard. Employment was down, but animal spirits were still running high with the computing boom, the advent of securitization, and new innovations in consumer credit.

Though I saw this rally coming a mile away, I have traded it very poorly. First, I put too much emphasis on picking the absolute bottom for a buy-in.  Back in Feb and March I got out of most of my shorts by the time we were under 700, and I entered a bunch of limit orders to put over 1/2 of my net worth in SPY on the long side. Unfortunately, those orders started at 620, and we bottomed at 666. So I missed the bounce, and not only that, starting in April I began to short the junk stocks that were flying the highest and have been the real driver of this market. That was way too soon, and they kept on going, to the surprise of many a long-short fund as well. The outperformance of junk was a surprise, but the overall bounce has not been. When you have mood as compressed as it was back in March and you reach an exhaustion point after 18 months of a strong bear trend, you get a big reversal, which can then generate the extremes of optimism needed to set up the next plunge.

I’ve been buying long-term puts on the S&P and Nasdaq again since late March (way too soon, considering that I expected the rally to continue). I bought a bunch more yesterday, by the way. I view it as extremely unlikely that this market doesn’t decline to the point where solid value offers support — that would be a sub-10 PE and dividend yield of over 5% on dividends that have to fall by 50% or more from here to around $12 for the S&P. That would be the 240 level, but it should take at least a couple more years to get there (or below), if not four or five.

What has always worried me as a short in this market is not a 5-8 month rally, but a 12-18 month affair  like some of those that Japan has experienced in its long bear market since 1989:

Source: Yahoo! finance

That said, Japan’s financial sector was deflating while exports were improving, families had savings and the rest of the world was growing. Today’s situation is much, much more severe of course, and we can only find a parallel in the Great Depression for so many of the economic trends we are seeing. The longest bounce in that bear market was 5 months, and it was of similar magnitude (48% from Nov. ’29 to April ’30; we’re up 47% in the 4.5 months since March 6).

This is the Dow from 1928 to 1931:

Source: Yahoo! finance

And here’s how that bounce looked from 1933:

Source: Yahoo! finance

The S&P500 is now the most overvalued in history by PE (infinite as of this quarter’s running 12 month total, or a dot-com-esque 32 times current annualized earnings levels, about $7.50 per quarter). The dividend yield is about 2.5%, but dividends are nearly as high as earnings right now, which is completely unsustainable (they should be less than half of earnings). On a sustainable basis, the yield is 1.0 – 1.25%.

Here is the S&P PE ratio (TTM data through 12.31.08) going back to 1936. (the dates read right to left, since I can’t figure out how to reverse them in Excel). Data through 6.30.09 would be off the chart:

Real (U-6) unemployment is approaching 17% and climbing, and that is if you exclude the likely 6 million illegal immigrants who are out of work now (who used to take home $100 per day as construction cleanup boys or dishwashers). Throw them in, as we would have in the 1930s, and you get a solidly depressionary 20%.


Credit is still being withdrawn everywhere you look, whether in home equity, credit cards or small business loans. There has been a bounce in the corporate bond market, but that is due to the same technical forces that are driving the stock market, and the big bankruptcies are just beginning. Only the very weakest have gone under so far, like the car companies.

So with this backdrop, I don’t expect this summer’s good feelings to last into the holidays. The markets should start to roll over again soon, since the big-money value investors needed for a sustained advance can find no reason to buy in, and the little guy has been burned too many times to chase this market very far. Volume is very thin, and an unusually large fraction of trading is taking place between automated programs.

When the data to back up the green shoots theory fails to show up after another few weeks or months, and even official unemployment is solidly into the double digits and climbing, while another huge wave of mortgage resets hits the middle class, there will be no hope at all left to support this market, and it will slide to levels not seen since George Bush Sr. was in office.

It will then still not be a safe long-term buy. For that, considering all of the obstacles that the government has created to profit-making, we need to get back to Reagan-era levels, somewhere under the bottom of the 1987 crash.

S&P500:

Source: Google finance

That old-time feeling…

Robert Prechter said back in February that some aspects of this bounce would resemble the euphoria of the all-time top in equities. Well, when I looked at the market today and saw that Amazon has rocketed up to its 2000 and 2007 peaks (albeit on pathetic and waning volume this go-around) and sports a 60+ PE, I got a tingle of that giddy feeling I had when I was buying puts hand over fist on stocks like this two years ago. Back then the whole market looked like this, but there are some great set-ups being formed this summer.

We are now solidly overbought as well as ridiculously overvalued. We may be witnessing the last gasp of the great post-1995 equity bubble.

Source: Yahoo! Finance

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A word of caution: when the NASDAQ runs like this, it can keep on going for weeks, so don’t get run over going short-term short. This kind of momentum should drive the VIX under 20 before long. That would signal near-total complacency in the face of economic fundamentals whose only parallel, and there can no longer be any dispute here, lies with the Great Depression: link to pdf from Sprott Asset Management.

It’s quiet out there

Where did the fear go?  While no one was looking, the VIX just made a new post-crash low:

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If today’s market were a fishing trip, it would be 88 degrees at 11AM on a flat sea with no clouds and no signs of life. The only movement out there seems to be range-bound trading in currencies (the dollar is at the very bottom of its recent range) and a mild decline in oil. Times like these are good for establishing positions, whatever they may be. You can set tight stops or buy cheap options.

If the VIX gets much closer to 20, I’ll buy a lot more long-dated OTM puts. When this market rolls over, the revulsion is going to be horrific. This time it will be the death-knell of America’s equity culture, the dependence on stock appreciation for everything from exhorbitant college costs to retirement. The safety net is going to get ripped away, just like unemployment benefits for those laid off last year.

Americans still have barely changed their spending habits and long-term plans, but a year from now they will have, and plenty of them will be very upset about it. But never fear, our leaders know how to provide outlets for such emotions.

Reflation trade stumbling

Trends reverse asset class by asset class. Here’s where the reflation trade stands about two weeks past its possible peak:

Gold and silver: Nice, clear tops and solid sell-offs. I’m pretty confident about those tops holding, since sentiment readings got so high there. Decent profits are in hand, and I am out of this market as of yesterday, since a corrective rally wouldn’t surprise me here. I am waiting to put on my shorts again.

Treasury bonds: Firm-looking bottom off very negative sentiment and a nice rally so far. There is room to go, though I have sold my calls and now just own TLT. Recent auctions have been very successful, as these nice yields are drawing the highest bid-to-cover ratios since 2007.

The dollar: Back within almost a percent of its recent low, but I’m not worried about a collapse because most people are already positioned for fresh lows. Today’s mini panic looks like a potential set-up for the bulls, and I am very long versus the pound, euro and franc.

Oil: Sentiment here never got extreme, but the chart looks toppy and this trade is not independent from general dollar/reflation fears. I am short futures with a tight stop, since today’s bounce took us right up underneath a clear resistance level. Fundamentally, oil is way overpriced for this environment. I still think $20 awaits at some point in the future.

Copper: Very similar to oil’s situation. No extremes, but toppy. I’m short with a tight stop. I expect $1.00 again at some point once the S&P drops under 600.

Pork: Ok, this has nothing to do with the rest of this market, but pork bellies and hogs have been nice winners for me lately. I believe there is a good chance that they just made a lasting low. The flu panic has never been anything but hot air — just another boogeyman to drive people to love big brother. When the fears fade, demand is going to outstrip supply. China bulls ought to be all over this: the Chinese love pork — they even have a “strategic pork reserve”.

Stocks: The markets were pretty oversold after yesterday, but today we worked off that condition, so anything can happen tomorrow. Everyone is watching the 880 level on the S&P, though it feels like after the 40% rally we could see more nasty 90% down days in the coming days or weeks, which would take us closer to 800 and give the bulls a real gut-check. 880 wouldn’t do that.

If we do get down under 850, things are going to get tricky: we’ll have to look at internals and sentiment to divine whether we’re due for a big recovery and re-test of the highs, or if we’re on the express train to new bear market lows.

It is also possible that we never get a deep sell-off, but just chop around within a 50-100 point range for a few more months while fundamentals deteriorate until Pangloss just can’t justify hitting the offer anymore. Chopping around the 900s without ever breaking clean through 1000 would be nearly as exhaustive for the bulls as this rally has been for the bears. It would draw them all in until none were left and volume dried up. That would be an awesome set-up for bears who aren’t themselves worn out in the chop.

This is why I’m such a fan of long-term puts for playing a bear market: with them you don’t have to worry much about how the market gets to its destination, so long as it arrives and on time. Right now, you can buy 36 months of leeway with December 2011 puts. I bought December 2008 puts in Q2 2006 and 2009s in 2007 — there was drawdown from rallies and time decay, but in the end it didn’t matter.

What a close. Down 473 points in 15 minutes.

I have built up a position in DIA Nov. 08 puts on rallies over the past couple of weeks, and with the Dow up 300 at 3:30 today, I couldn’t resist adding a few more than I would ordinarily be comfortable with. I intended to part with the extra contracts maybe tomorrow or the next day in the inevitable correction after such an awesome rally (1,208 points, 14.8%). As it turned out, the Dow proceeded to drop 473 points in about 15 minutes, and I unloaded the contracts at the close for the fastest money I’ve ever made (as regular readers know, I’m more fond of buying LEAPs to capture the big, multi-month moves).

From Bigcharts.com, here’s the 1-day chart (1 minute):

Click image for sharper view.

As I count the Elliott Waves, this pattern has the A-B-C shape characteristic of a countertrend move, so it doesn’t change my expectation for new index lows in the coming days or couple of weeks. The mini-crash at the close looks like waves 1, 2, 3 and 4 of an impulse wave, which would resolve with another drop below the wave 4 low near the open tomorrow. Impulse waves move in the direction of the one-larger degree trend, as opposed to A-B-C moves.

Today’s chart also illustrates another textbook pattern: the contracting zig-zag from 2:40 to 3:15 resolved in the direction of the previous trend — up, way up. The 1-month pattern is still a very large contracting zig-zag, which, should it stay true to form, would resolve downwards, perhaps to Dow 7000, though a push above the October 14th high first is also possible:

Click for sharper view.

All of this near-term wave counting and trading is really just a hobby for me. I don’t use big money in it, but just enough to keep my attention so that I learn something. My real money is in T-bills, gold and still a boatload of 2010 puts that I accumulated over the last 15 months (see disclaimer), though I have been paring that position in the crash. If I hadn’t been selling, it would be about 85% of my portfolio by now.

Sorry for the paucity of posts lately. I’m in the middle of a trans-oceanic move, ditching a ridiculous Latin American country for a central European one known for staying sane while the rest of the world goes nuts.

Stocks are very expensive. Mr. Market is still in denial.

Bottom line: Declines in earnings and mood could result in an 80% drop in stock prices from here.

The S&P 500 is still priced at over 15 times last year’s earnings ($66 as reported*). Since the late ’90s, corporate earnings have been as inflated as the rest of the economy by cheap credit. From 2003, they spiked up even further, way out of line with long-term trends, largely due to inflated financial profits from the real estate scam and consumer-related and other income from society-wide profligacy. Here’s a 20-year chart:

Click image for larger view. Source: Techfarm

Mean reversion

To make matters worse, in the optimism of the bubble environment, investors extrapolated the recent pace of earnings growth out into the distant future, completely forgetting that growth is mean-reverting. This long-term mean in the US has been about 6% (good luck keeping that up under socialism). Earnings growth will always revert to a mean in a market economy simply because excess earnings attract competition. In an economy with government-supported fractional reserve lending, the downside of the credit cycle will also undercut earnings (and generate large losses).

2006 S&P 500 earnings of $81.51 were an extreme historical anomaly, so applying a 19-handle to them was insanity. If Mr. Market hadn’t been so hopped up on the energy drinks popular at the time, he would have thought long and hard before paying more than $8 for 2006 earnings, especially because stocks were hardly paying any dividends at all.

The first two quarters of 2008 came in with $15.54 and $13.17 in earnings, respectively. If you assume that each of the remaining quarters will be worse than the last by $2 (pretty optimistic if you ask me), you come up with a final 2008 figure of $49.

Mood swings

When thinking about what to pay for those earnings, you want to think about what kind of mood Mr. Market will be in next year. Somehow, I don’t think he’ll be quite as optimistic as of late, since the aftermath of that tuarine/caffeine cocktail can be a downer. After such a frenzy, his mood typically declines for years and doesn’t turn up again until he has put a sub-10 multiple on recession year earnings.

Looking at past episodes, the odds are strong that Mr. Market pays less than $12 for each dollar of 2008 earnings by the end of 2009: an index value of 588 using our ’08 estimate.

But then 2009 earnings aren’t looking so rosy either: even sell-side analysts are predicting that they will be lower than this year’s. Extrapolating a decline of $1 per quarter from our $9.17 estimate for Q4 ’08, you get $27 per the index for 2009. This happens to be about what the 500 earned in the mild recessionary year of 2002. Think next year will be worse? Adjust accordingly.

Whatever your own ’09 estimate, keep in mind that Mr. Market will be downright angry with stocks’ performance and extremely cynical by the time 2010 rolls around. If history is any guide, by the end of 2010 he might not even pay $8 for those earnings. That would be an S&P 500 value just north of 200.

Got LEAPs puts? You can bet on earnings and Mr. Market’s mood out to December 2010 with options on SPY.**

*S&P provides a big Excel spreadsheet of such figures here (download).

**See disclaimer. I own a ton of these.

ProShares announcement: it was the ban.

ProShares Announcement
Friday September 19, 11:25 am ET

BETHESDA, Md.–(BUSINESS WIRE)–Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice. Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets today, but may trade at prices that are not in line with their intraday indicative values.

No more SKF for me, ever. I’m on an accelerated schedule to get out of the rest of my short ETFs. Too many wild cards, not enough disclosure.

Long-term puts only from now on. I had hoped to hold onto the ETFs until we started to really plunge, because I had figured market functions would hold up that long, but we are apparently on an express train to Animal Farm.

I wonder how many others feel the same? I bet this week’s shenanigans are going to put a lot of people off the markets entirely. All they have done is burn a few shorts and set the markets up for a rapid retracement of the last 900 Dow points, plus give or take a couple thousand to the downside.

Markets don’t drop because of shorts (though shorts can drive them up fast). Markets drop with the scales off of longs’ eyes.